IACCM recently hosted a roundtable discussion to explore industry attitudes towards contracts based on ‘payment by results’.
As buyers shift from seeking low price to value for money, it is inevitable that suppliers will be expected to commit more firmly to performance. This typically extends the period of engagement for the supplier and leads to the question “When should I be paid?” Many buyers – business and consumer – will increasingly expect that value is visible prior to payment, in whole or in part.
For Governments, ideas like payment by results have particular attraction. They see it not only as a way of encouraging supplier honesty and performance, but also of demonstrating responsible handling of public funds. Therefore the results of this roundtable discussion are being shared with the UK’s National Audit Office as it explores developing guidance on ‘payment by result’ contracts.
There are problems with this approach – some practical, others reflecting attitudes. For example, will such an approach simply lead to higher prices because of the perceived additional risks? Will it result in major suppliers deciding not to bid? Is payment by results compatible with other Government policies, such as expanding business awarded to small and medium enterprises? With regard to attitudes, there was a degree of cynicism at the table that this was just another way for the public sector to avoid its responsibilities in driving good performance. The point was made that many contracts are risky because the customer doesn’t really know what they want, or there is political interference, or the client lacks skills at performance management. In these circumstances, payment by results will not fix the problems.
One participant made the observation that buyers must understand the overall supply chain before moving in this direction. It is not only a question of whether the contracted supplier is willing to work on this basis, but also whether they can impose similar terms onto their suppliers. In many industries, the market lacks real competitiveness and tier one suppliers may simply refuse to do business in this way.
A wide-ranging discussion resulted in many ideas and insights, which are being turned into a summary paper. Please add your comments or experiences. This is a subject that shows every sign of growing in importance.
Contracts are written to reflect a wide variety of business policies and practices, as well as product or service capabilities. At a time of rapid change, it is inevitable that terms need continuous review and update.
Examples of change come in the form of regulation – for example, the European Union and payment terms, the US and revised revenue recognition, China and software code. It may be driven by market volatility – for example $50 oil, turmoil in the Middle East, the emergence of the AIIB – or the challenges created by growing social transparency and reducing trust – for example, the recent initiatives by Microsoft and Amazon regarding labor practices, or the more general trend towards supplier responsibility for outcomes.
Existing contract models are often not appropriate; traditional templates and terms are too rigid; perceptions and evaluations of risk are too narrow. Contracting processes are struggling to catch up with the trends towards empowerment and self-help. These factors cause contracts to be viewed as inhibitors to getting business done. For many organizations, this results either in lengthening cycle times for negotiation and drafting (as demonstrated by IACCM’s recent benchmark study) or in contracts that are simply not suited to the purpose for which they are used.
Overall, this means that the incidence of financial loss from poor contracting is increasing.
Driving improvement is difficult because in most organizations there is no clear owner of the contracting process. In those organizations where leadership does exist, several areas of improvement are starting to emerge:
– shifting appreciation of risk, focusing more on analyzing the likelihood of risks occurring
– greater use of relational and performance based contracts (which IACCM research suggests cut failure rates by up to 50%)
– growing sophistication in the use of agile contracting models, with work to reconcile budgeting and forecasting systems
– user-based contract models and tools, to ensure fast and accurate dissemination to those who are responsible for implementation and performance
– analysis of contracts for business intelligence – in particular insight gathered from across the contract portfolio, not just individual transactions
For those leading these changes, contracts do indeed become a business enabler and a source of competitive difference. They reflect businesses that are adept at change – and therefore far more reliable trading partners.
“We have a mix of customers, some on contract and some without contracts. I analyzed customer satisfaction results – and found those with contracts are almost twice as happy as those without. The contracting process results in clear expectations and more disciplined performance.”
This insight came during a discussion at an IACCM member meeting in the UK – and it was from a representative who works in a major international corporation. Once again, it reinforces the observation made in one of my recent blogs – “contracts are a framework for business operations”.
That automatically points to the role that contracts play in driving business efficiency. But the latest IACCM benchmark data reveals that it isn’t just the contract that matters – it is also having a structured contract management organization. Companies that operate with a full-time contracts or commercial organization use approximately 35% less resources than those where contract management is performed in a devolved fashion, or as an element of other jobs.
The IACCM study gathered input on where and how the contract management role is performed. As part of the data, it explored the number of FTEs used to perform contract management tasks. In many organizations, there are dedicated practitioners, plus others (for example in Sales, Project Management, Procurement or Legal) for whom it is part of their role. What we discovered is that the overall number of FTEs required to operate in a devolved organization or where contract management is just a component of a job is substantially greater than the number needed when there is a consolidated contract management function. On average, this represents around 40 heads, but in large corporations (over $40bn annual revenue) this can increase to several hundred FTEs.
51% of contract managers say that payment terms have become a more contentious issue in their negotiations, with many smaller companies under pressure to accept longer payment periods. Overall, 70% of companies say that they have adjusted their standard payment terms during the last 2 years.
In a recent IACCM survey, 18% of major corporations (those with over $40bn annual revenue) acknowledge that they now pay suppliers on 90 day (or more) terms. This compares with just 5% of smaller companies (revenue up to $10bn). Larger corporations are also more likely to impose ‘early payment discounts’.
40% of smaller companies report that more onerous payment terms are being imposed on them by their customers. This compares with just 22% of large corporations facing the same pressure. There is universal agreement that the main factor determining acceptance of these provisions is negotiating power (59%), followed by ‘the nature of the relationship’ (43%). Just 25% say that they vary terms based on geography or market segment – pointing to the trend towards universal consistency.
However, important regional variations remain in place. For example, in the US, the trigger for invoicing often remains ‘shipment’ – a concept rarely used elsewhere. In the Middle East, Africa and Asia, there is a greater tendency to invoice on acceptance and for the payment period to commence on receipt of invoice – but these more generous terms are accompanied by 30 days remaining the norm for the payment period.
Smaller companies also experience greater difficulty in getting paid. 77% say that customers typically adhere to the payment terms, whereas this rises to 92% for large corporations.
The survey also revealed that European companies are the most likely to use outsourced payment centers, with 20% making use of such services, versus 15% in the United States and just 9% in Asia.
The reasons for extensive negotiation immediately become apparent when comparing the standard positions of buyers versus sellers. For example, 67% of suppliers still attempt to operate on 30 day terms. Just 16% of suppliers include early payment discount in their contracts, whereas 40% of customers seek such discounts. When it comes to charges for late payment, the position is of course reversed – with 60% of suppliers seeking such terms and 29% of buyers accepting them.
Many of those surveyed do not expect any reduction in the pressure on payment term negotiations. They anticipate that businesses will continue to see extended payment as a mechanism to enhance cash flow; they also anticipate increased levels of factoring / supply chain finance; more discounts for early payment; and continuing standardization across business units.
The IACCM survey was conducted in March/April 2015 and gathered input from almost 600 corporations. Full results will be issued by the end of April.
Last week, one of my blogs included observations on the way that attitudes to contracts are changing. In response, drafting guru Ken Adams challenged my suggestion that these shifting attitudes will lead to fundamental changes in contract design. I think his implication is that change, to the extent it happens, will not significantly impact contract structure, but will simply move from undisciplined pedantry to an alternative and more rigid style of authoring, based on his style guides.
The challenge is valid. Legal form is long established and the profession is slow to change, especially in areas where the resulting benefits are uncertain. So on what basis do I believe that change will occur?
There are a number of dynamic forces:
- Social pressure – people are demanding greater clarity. Indeed, even the CEO community now believes that a reputation for honesty and integrity is fundamental to business success and this is affecting approaches to terms and conditions..
- Generational pressure – new approaches to communication, intolerance of complexity New technologies and media have resulted in the expectation that communication is clear and honest.
- Technology – analytics are demonstrating the relative importance of different risks and the consequences of those risks. High among them: inefficiency and ineffectiveness of ‘traditional’ contracts which then damage financial performance.
- Pressure on lawyers to perform – as with medicine, there is an increasing focus on prevention – from contracts as a source of risk to contracts that manage risk.
So those are among the forces. Where is the evidence that this is actually leading to change? Here are some examples. Law schools, even law firms, are now actively working on new approaches to contracts based on artificial intelligence and the need for machine readable data. General Counsels are wanting to know the precise link between contract terms and economic impacts. Cross-industry groups are working to establish industry standards and to escape the inefficiencies and delays created by the ‘battle of the forms’. In-house legal groups increasingly appreciate their role is to enable the business, not to sit in judgment on it. There is growing acknowledgement that recourse to the courts is no longer relevant for many forms of agreement and therefore strict ‘legalese’ is unnecessary. Then there is the fact that other complex documents – such as engineering drawings – are moving into the virtual world and in the process discovering that such a move saves time and money. Finally, law schools are starting to include practical programs about contracts and contract management, preparing future lawyers to work in business, not in the courts.
Ultimately, change is most often driven by economics. And the economic case for new approaches to contracting is becoming more evident and is compelling. I understand that from where Ken sits, the pressures – and reactions to them – may be less visible. Ultimately, even something as traditional and formalized as contracts cannot stand in the way of progress.
“We must think about contracts as the foundation for business operations”, observed Steve Harmon, Deputy General Counsel at Cisco. “We’ve reached the end for strategic ambiguity in contracts – there is a need for far more clarity”.
Steve, along with Paul Lippe, CEO of LegalonRamp, was a presenter on a recent IACCM webinar exploring the implications of the new ASC606 revenue recognition standard, due to be implemented in the US (a recording is available in the IACCM member library).
The standard is significant in that it is just one more step forcing organizations to have clarity and precision in their contracts, enabling unambiguous data extraction and management. The regulation forces organizations to unbundle their contract obligations and take revenue only as each obligation is fulfilled. That means contracts staff must be far more aware of the various cost elements within a contract and to ensure there is not only clarity within the terms, but that relevant commitments and obligations are then flowed into the business and actively monitored.
This requirement simply reinforces the existing pressures for better designed contracts and for robust processes supporting data extraction, dissemination and monitoring. It plays to existing trends – such as offshore centers to undertake extraction, more sophisticated contract management systems, growing focus on the role of ‘contract owners’. As Steve Harmon also observed when talking about CLM applications: “We need to publish the implications of contract terms, not just simplify their creation”.
In summary, we are looking at contracts and their management becoming a core capability for businesses, rather than a peripheral area of administration. Contracts have been obscure, yet now they must be increasingly transparent and designed for active use. These are challenging changes for all the professionals traditionally involved in their creation and management. The pervasive nature of contract terms means that many people in the business are affected. Indeed, just yesterday I was writing an article for a Sales journal, explaining the impacts on the traditional sales and account management teams.
Over the next two years, we will see a fundamental reappraisal of contract design and wording, challenging the way that traditional legal drafting has occurred. We will see fundamental changes in the software to support contract management, as artificial intelligence and machine readable data facilitate extraction and dissemination of information. We will see fundamental changes in the way that contract portfolio performance is monitored and business intelligence is generated to drive marketing and policy decisions, as well as far greater sophistication in understanding and managing risk. And this means we will without doubt see fundamental changes in the way that contract management skills are developed and deployed.
As part of the mounting social debate over ethics and perceived fairness, the UKs Labour Party has announced that suppliers to the National Health Service will not be permitted to make more than 5% profit.
The intent here may be to ensure the exclusion of private business from health services, but that would seem to lead to their inevitable collapse, since there is complete dependency on the private sector for drugs and equipment. So perhaps it is simply a target number, or a way to impose price pressure at a time when current procurement practices have largely stripped the fat from supplier pricing. Most likely, it is just unattainable populist politics.
But behind the headline is a serious issue and that is around the growing questions over ‘permissible’ levels of profit. This is a complex area, since profits – and the need for them – vary dramatically. Commodity businesses, with low costs of entry, constantly struggle to make or maintain margin; many retail sectors are a case in point. Such sectors are often under public and political pressure to mimimize prices, yet often the only ways they can do this are either by cutting service levels or pressuring their own (often small) suppliers. In both cases, they are then criticized by those same people who demanded the lower price. Another example is utilities, where true competition is often difficult to achieve because of the underlying monopoly in infrastructure. Again, prices in this industry are a political football, since everyone needs access. Companies in the energy industry struggle to make profit and are then accused of failing to make investments in the infrastructure and supply network. Today, many energy companies can make more money by helping customers use less energy than they can by selling them the energy itself.
To add to the irony of the situation, recent research discovered that consumers actually accept being ‘ripped off’ by their favorite brands, so long as there is transparency in pricing! It is certainly notable how little pressure there is on a company like Apple, despite its remarkable profitability and cash pile. This leads us to another aspect of modern pricing, which is the issue of open-book accounting. Certainly it is a focus for Governments. Yet once again, even if socially desirable, the formula is complicated. The definition of an acceptable margin must take account of circumstances. For example, price should bear a direct correlation to risk. It should also link to the potential for innovation and investment. And for a multi-project supplier, should margin be limited on each project, or across the entire portfolio?
One thing seems certain: debates on pricing and on the morality of profit are unlikely to go away. The digital age means that every business has to live with increased visibility and needs to accept that it will face demands for greater transparency and for justifications of its pricing policies.